Category Archives: Finance

Which is Preferable C or S-Corp Status? Six Suggestions

Situation: A company’s accountant advises them to transition from a C Corporation to an S Corporation. Remaining a C Corp would force them into accrual accounting with significant tax consequences. The accountant also advises that it is easier to sell an S Corp to a buyer, and S Corp status would relieve problems with retained earnings. Which do you think is preferable, C or S Corp status?

Advice from the CEOs:

  • Accountants disagree. Get a second opinion. Also consult a tax or corporate lawyer who will provide another perspective.
  • Another company looked at S vs. C status and found two key factors:
    • S Corp status is great if you expect to lose money for a few years because of the benefit that it can offer to personal taxes. Over the long-term you should look at the difference between personal and corporate tax rates and set your strategy so that it makes the most sense.
    • An S Corp cannot have non-U.S. shareholders.
  • There is more flexibility with C Corp status in your ability to grant options, sell shares, etc. For a suitor, purchase of C Corp shares prior to a full acquisition is like a date before deciding on marriage.
  • C Corp status is good if you are building an empire. S Corp status is better if want to have employee ownership under an ESOP as an option for exit.
  • Since taxes are a significant part of this decision, think carefully before you shift from cash accounting.
    • Once you commit to accrual accounting you can’t go back to cash basis.
    • To the extent have an accrued tax liability you can extend payment of this liability over multiple years.
  • You also may want to consider a hybrid accounting method:
    • Accrual for sales
    • Cash for service
    • Look at whether there are tax advantages to a hybrid model.

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How Do You Manage Cash Flow and Growth? Five Thoughts

Situation: A company faces dual challenges – assuring that payments are collected for work done and developing a business model that facilitates growth. How do assure that payments are collected to support your cash flow needs and that employees are focused on growth?

Advice from the CEOs:

  • It may be that the two problems are closely related. Ask whether your compensation and incentive system is focused on cash flow and growth. If not, you need to change it.
    • Restructure your compensation and incentive systems to create a direct link between profitability and compensation. Augment this with training. For example, if your engineering team isn’t good at assuring that change order costs are paid by their clients, teach them how to write statements of work to anticipate change requests and to include charges in the SOW. Then tie the team’s compensation to how well team members follow though in assuring that work is properly accounted for, billed, and payment collected.
  • Create simple procedures that are innate and complementary to team members’ natural behavior. The best way to do this is to involve them in the writing of the procedures.
  • Give them easy tools that take the guesswork out of negotiating change orders with clients. For example, if a client asks for faster delivery, give them a formula that ties delivery to cost::
    • Standard Delivery = 8 weeks at Price X
    • 4 Week Delivery = Standard delivery price times Y
    • 2 Week Delivery = Standard delivery price times Z

This turns client demands into a simple economic question – what is expedited delivery worth to you?

  • Hire a contracts manager to track contracts and change orders with authority to assure that change order costs are being billed.
  • Create “learning” teams to develop solutions. Allow the teams to speak to each other and to learn each other’s best practices. Supplement this with regular tutorial sessions to bring the whole group up to speed on new technologies.

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What Will Happen to HSA Accounts Under the Affordable Care Act?

Situation:  To maintain expense control as the Affordable Care Act is implemented, a company is looking at HSA options to replace their past insurance coverage. What do you think is the future of HSA policies and accounts as the ACA is implemented?

Advice from the CEOs:

  • HSA Accounts are expected to survive implementation of the ACA, at least for now, and may even thrive (Forbes Magazine analysis, 3/27/13).
  • The HSA Model combines a relatively inexpensive high deductible health insurance policy (minimum deductibles in 2013 at least $1,250 for individual and $2,500 for family coverage) with an HSA Account. Employer or employee contributions go into the account pre-tax. Most insurers offer a high deductible policy and many companies have adopted this option because it helps to control the growth in health care costs.
  • Annual HSA contributions are limited to the amount of the deductible, currently up to $3,250 for individual and $6,450 for family coverage, though these amounts are increased by $1,000 of the employee is 55 or older. Contributions are held in a bank account and can be withdrawn by the employee to cover most out of pocket health expenses. This is under an honor system, subject to possible audit by the IRS.
  • The key component that differentiates HSA Accounts from older health reserve accounts is that if the funds deposited annually are all not used to pay for health costs, the employee gets to keep the excess funds in the account. If the employee builds up excess funds in HSA Account, these can be transferred into an IRA. Check with your HSA bank for rules as to transfer of IRA funds back into the HSA Account if needed to cover out of pocket health care costs.
  • The down-side of the HSA Account is that if the employee encounters a significant health cost, above the amount in their HSA Account, they will have to cover this out of pocket. However, they have the option to reimburse themselves from future HSA contributions as these accrue.
  • If you are considering this for your company, it is advisable to hire a consultant to help you tailor the plan to the specific needs of your company.

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How Do You Negotiate New Shares for the Founders? Five Suggestions

Situation: A company’s founders will be fully vested in their options by the end of the year. Also, the option pool for founders and employees has been exhausted. The CEO has spoken with the Board Chair and Compensation Committee about this in terms of fairness and incentives for future work to both founders and employees, while making it clear that the Founders are not unhappy. The Chair listened sympathetically and promised to get back to the CEO. Is there anything more that the CEO should do to negotiate new shares for founders and employees?

Advice from the CEOs:

  • Seek a letter of understanding from the Board that the founders and employees will have access to future stock incentives, and a timeline as to when this might occur – either in the near future or at the next financing round.
  • Wait a few weeks and have an informal follow-up conversation with the Chair about his current thinking. Ask whether he would like any further supporting information on the issue.
  • So far, your approach has been non-threatening. Keep it this way.
  • Maintain focus on fairness and your tone supportive of the best interests of the company.
  • Don’t press the issue if you sense resistance.

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How Do You Value the Stock of a Private Company? Three Factors

Situation: A private company has not issued stock options in over 6 months. The business press highlights concerns over appropriate valuation at the time of option grant. How do you value the stock of a private company to assure that option awards reflect proper company value?

Advice from the CEOs:

  • Decide on the objectives of your valuation exercise. These may include:
    • A credible valuation to protect the Board from challenges over option valuation.
    • A calculation that the company can use quarterly or semi-annually to assess company valuation; possibly something that can be done internally on a quarterly basis, with independent validation annually.
  • Given that your concern is option valuation and protection of your Board, they only clean way to do this is to have an outside party perform your valuation. Internal valuations are subject to challenge. Look for reputable CPAs that specialize in private company stock valuation and get quotes from several for initial valuations plus follow-up valuations in 12 months. You may anticipate paying a fee of $12,000 to $15,000+ for this service.
  • There are issues that you will want to address in your valuation process:
    • A valuation must have a supportable rationale and demonstrate consistency of methodology so that valuations will be performed on a comparable basis year after year.
    • You want to see consistency between valuations with your annual financial audits which will reflect company performance.
    • There are at least two models that you may follow – a hard model and a soft model.
      • The hard model is a one-time valuation based on your financials. This may include historic performance, as well as forward-looking ROI.
      • The soft model is based on operational and risk assessment.

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Arbitration or Suit to Settle a Dispute? Five Factors

Situation: A company has a long-term client that stopped a project suddenly 6 weeks ago with no explanation. Later, the client called saying that they do not intend to pay for work completed to date. Would you pursue either arbitration or injunctive relief to settle this dispute?

Advice from the CEOs:

  • If you have evidence of acceptance of a project contract or other documentation that the work proceeded under agreement with the client, this strengthens your position.
  • There may be other circumstances of which you are unaware such as financial or cash flow difficulties. Inquire through discrete channels to clarify this. Knowledge of the inside situation provides leverage as you negotiate a settlement.
  • Do you want to retain this client? If they have been valuable over the years this may just be the behavior of a single individual. If this is the case, work with your key contacts to bring this situation to light and try to solve the problem without legal action.
  • Because you have a long-term relationship with the client, focus your communications on the President rather than the VP who shut down the project.
    • Established your documentation, and complete your research on whether the client has cash flow problems; then call the President to work out an amiable resolution.
    • While you are justified in feeling miffed about the situation, business is business, and in this case it appears that your long-term relationship and the value of the ongoing business with the client outweigh the emotion of the present situation.
  • Focus on resolution of the dispute between the parties and do everything possible to resolve it between the companies rather than through legal avenues. This will help preserve the relationship with the client. Provided that you continue with this client, clean up the portion of the contract specifying notification and acceptance requirements and other areas of the contract that require attention.

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How Do You Maximize Shareholder Value and Liquidity? Four Factors

Situation: A private company creates a liquidity event every 3-5 years: selling pieces of the company, product-based spin-offs, or potentially the whole company. Most frequently, engineering efforts spin off opportunities for new product-based companies. How do you measure company or business valuation with the objective of maximizing shareholder value and liquidity?

Advice from the CEOs:

  • Look at a model to create productized service offerings that are replicable and predictable. This can create a stream of spin-offs to generate ongoing liquidity events. Jack Stack’s company, Springfield Remanufacturing has done this very effectively over the past two decades. He describes his methods in The Great Game of Business.
  • Regarding selling the whole company, the most important measure is strong company performance in recent quarters. Focus on internal metrics as well as revenue and profitability performance. Put together a solid 3 to 4 quarters of profitability with an upward trend to increase appeal to potential acquirers. The current market requires both a longer history of profitable performance and more data points of performance than was required in the previous decades.
  • To compliment internal measures develop a relationship with a business broker who can help you assess the value of either product or company spin-offs. A broker can determine the current value of the opportunity as well as a timeline and critical actions to enhance opportunity value.
  • Consider a roll-up of your company and one or more of your business partners.
    • Look for similar or compatible financial structures and complimentary capabilities.
    • A roll-up can broaden your range of products and services. As a bigger entity you have more options, and can enhance your ability either to generate spin-offs or become a more interesting acquisition candidate.
    • The downside is the time that it takes to complete the roll-up if you feel you have a short window of opportunity.

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How Do You Evaluate A New Business Opportunity? Six Questions

Situation: A company has been presented with a new business opportunity. The opportunity is compatible with the company’s current business, but also involves skills and markets with which the company is not familiar. How do you evaluate a new business opportunity?

Advice from the CEOs:

  • There are at least four critical questions to assess as you evaluate any new businesses opportunity:
    • What is the total available market, and what is the immediately convertible market for the product or service?
    • Can you acquire expertise in the new markets that this will open to you?
    • Do you have a track record starting and nurturing new business within your company?
    • Is there sufficient seed money available – through company funds or outside investment – to keep the effort going for at least a couple of years as you develop the core team that will operate this business and gain traction?
  • If there is an offer of outside investment, consider how many months this funding will support the salaries of the team that will build this business, plus operating and overhead costs. You want to be sure to give yourself an adequate runway.
  • New business development opportunities typically require huge energy, creativity and focus for the first few years. Key management will have to devote all of their effort during the start-up period. Can the company afford to lose the services of key personnel for the time that you estimate this effort will take?
  • Before deciding to pursue this opportunity, take the time to investigate the market for this opportunity.
    • In particular, look for other companies that have tried to enter this market, and learn from their experience.
    • Develop a network of advisors who understand this market and can help you understand both the workings of the market and why companies may have struggled trying to enter the market.

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How Can You Unwind a Redemption Clause? Six Options

Situation: A company exchanged a small percent of their stock for a Series A unsecured note 4.5 years ago. The company has not undergone an IPO because of the recession and if the note is not repaid in 5 years, the holder has the right to call the line. If the company can’t repay the line, the holder gains governance rights. Revenue declined during the recession and while it is on the upswing, the company doesn’t have the cash to repay the note. What are the best alternatives for the company to unwind this redemption clause?

Advice from the CEOs:

  • Raising money to repay the debt will be problematic because of the current liability. Investors want their investment to fund growth and returns, not to simply repay debt.
  • Assuming that your revenue rebound is sustainable can you prioritize resources to accumulate cash to repay the note? Jack Stack, in The Great Game of Business describes how he was able to rally his company’s employees to pay off a seemingly impossible debt load in one year to save his company,
  • If raising the cash to pay the note is impossible, you have 5 options:
    • Convert the note to long-term debt that you can service.
    • Convert the note to equity at a lower evaluation and take some dilution.
    • Renew and push out the note, with a sweetener.
    • A combination of the above.
    • File Chapter 11 if you can’t produce or raise the funds.
  • Have your options in place at least 2-3 months before the note is due. This gives you time to talk to and bargain with the note holder.
  • Start a PR campaign with the note holder.
    • Look for leading and lagging indicators that show your progress.
    • Build a story that lends credibility to your forecasts of future success.
    • Pitch that you are a good long-term investment, and now is the prime time to trade the note for equity.
    • Prep the holder, and build this story gradually over time.

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How Do You Structure Your Bookkeeping Function? Four Suggestions

Situation: A small company has a long term clerk employee. This individual is responsible for AR/AP, Payroll and also HR manuals and reports to the CEO. This individual has been a good employee, but doesn’t perform well in this role. How would you structure accounting and bookkeeping in a small company?

Advice from the CEOs:

  • This is a key role, but there are a number of options. One is for the individual to continue reporting to the CEO, but train someone else to back them up. This will enable you to either shift the individual to another, more appropriate role within the company, or to continue with minimal disruption if the individual leaves.
  • Because of history and loyalty, this is a difficult emotional issue for you as CEO. It is important to consider what you would do if you could remove your emotions from the issue. If the answer is that you would eliminate the clerk position and hire a qualified, experienced bookkeeper at the appropriate salary, then this is your answer.
  • Packard’s Law – from one of HP’s founders – is that no company can grow beyond the capabilities of their employees. Hire the right person. This individual must be process-oriented – someone who routinely checks their own work to make sure that it is right. There is an adage in accounting that good accounting is 20% knowledge and 80% double checking the work. Hire a person who loves to do this.
  • Take care of this position in the best interests of the company, and look for another, more appropriate within the company job for the clerk.

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